BSM: Fixed Income Portfolio ManagementReference Curve Discussion

For the Record

• Risk Free Curves Do not Exist!• The Regulator should not prescribed the

Curve, because swap and govie are both acceptable strategies.

• The regulator should not dictate investment or hedging strategy pursued by investment professionals

• Quantify and Measure Basis Risk and apply capital

The search for a “risk free” curve

• Definition of risk free• Ability of the issuer or seller to meet obligations• Guarantee that their will be a curve in a meltdown or

severe dislocation• Only two options to consider, the government

(government bonds) or the banks (swap market)

• Europe does not have a euro government issued risk free curve, hence the swap curve was chosen to span all countries in the Euro area.

Considerations,

• Most life companies liabilities are funded, so is a government bond purchase. There is a premium to be received for tying up cash.

• A swap position only gets funded to the extend of the mark to market change. Swaps by its nature is a geared position.

• Governments can raise taxes, banks can’t• Systemic risks can develop if both insurance companies and

banks rely on the swap market.• Why is SAM not concerned with Basis Risk (matching

premium)??• Who will fund the government if swap is regarded as risk free

and what does it say about bank versus government risk.• Illiquid inflation linked swap market.

Illiquid Inflation Swap Market

SASWIT10 CurncyDate PX_LAST PX_BID PX_ASK Bidoffer

2012/10/26 6.606 6.506 6.706 0.200 29/10/2012 6.693 6.290 6.790 0.500 30/10/2012 6.724 6.624 6.824 0.200 31/10/2012 6.833 6.733 6.933 0.200 01/11/2012 6.800 6.500 7.000 0.500 02/11/2012 6.829 6.729 6.929 0.200 05/11/2012 6.770 6.520 7.020 0.500 06/11/2012 6.843 6.743 6.943 0.200 07/11/2012 6.765 6.410 6.910 0.500 08/11/2012 6.675 6.575 6.775 0.200 09/11/2012 6.620 6.370 6.870 0.500 12/11/2012 6.657 6.557 6.757 0.200 13/11/2012 6.630 6.380 6.880 0.500 14/11/2012 6.667 6.567 6.767 0.200 15/11/2012 6.629 6.529 6.729 0.200 16/11/2012 6.620 6.370 6.870 0.500 19/11/2012 6.570 6.320 6.820 0.500 20/11/2012 6.490 6.240 6.740 0.500 21/11/2012 6.533 6.180 6.680 0.500 22/11/2012 6.705 6.350 6.850 0.500 23/11/2012 6.698 6.598 6.798 0.200 26/11/2012 6.686 6.586 6.786 0.200

If the ILB swap market was Liquid……

23/11/201223/06/201323/01/201423/08/201423/03/201523/10/201523/05/201623/12/201623/07/201723/02/201823/09/201823/04/201923/11/201923/06/202023/01/202123/08/202123/03/202223/10/202223/05/202323/12/202323/07/202423/02/202523/09/202523/04/202623/11/202623/06/202723/01/202823/08/202823/03/202923/10/202923/05/203023/12/203023/07/203123/02/203223/09/203223/04/203323/11/203323/06/203423/01/203523/08/203523/03/203623/10/203623/05/203723/12/203723/07/203823/02/203923/09/203923/04/204023/11/204023/06/204123/01/204223/08/2042

5.00%

5.50%

6.00%

6.50%

7.00%

7.50%

8.00%

8.50%

Bond Breakeven Swap Breakeven

As Oppose to the ILBs

Bond Maturity BID ASK BidofferR211 -0.070% -0.120% 0.050%R212 1.020% 0.970% 0.050%R197 1.150% 1.100% 0.050%I2025 1.270% 1.220% 0.050%R210 1.550% 1.500% 0.050%R202 1.820% 1.770% 0.050%I2038 1.910% 1.860% 0.050%I2050 2.040% 1.990% 0.050%